Occupational Choice and the Process of

Development

Benerjee and Newman, JPE 1993ECON4915

Spring 2010

1 Dynamics of occupational choices and devel-

opment process

The motivational question -

• Reasons behind the evolution of different economics institutions (form oforganization of production)

The paper connects occupational choices and income/wealth distribution, whichin turn determines economic growth in this framework.

How occupational choice may affect process of development?

• Occupational choice, as defined here, refers to a contractual arrangementrather than a specific activity. e.g., self employment, factory workers,entrepreneurs.

• Development - a broad concept -

— Economic growth (affected by economic variables such as savings, in-vestment, risk bearing)

— Transformation/evolution of economic institutions (form of organiza-tional production)

The effect is not necessarily unidirectional.

Effect of developmental process on occupational choice may come throughvarious channels

• Demand and supply of labour changes

• Demand for entrepreneurship evolves

This paper connects the two aspects through the intermediary roles of wealth/incomedistribution.

Implicit assumptions in the analysis

• An imperfect credit market, as we have seen in BU, access to credit isconstrained by wealth (ability of provide collateral).

• Given the imperfect credit market and an initial wealth distribution, wewill derive a pattern of occupational choice behavior.

• Occupational choice determines current period income, and through sav-ings (of a part of income), we get the next period wealth distribution.

First part

Building a model that characterizes the effect of income distribution on occu-pational choice

A continuum of agents, and time is continuous.

In an interval of time dt, a measure λGt (w) dt are active agents with wealthbelow w.

Agents are risk neutral with preferences

cγb1−γ − zIt is easy to see that with c+ b = y (income), the maximum utility can simplybe expressed as the following expression of income

δy − z, where δ = γγ (1− γ)1−γ .

Choice of occupation

There is a fixed safe asset, yielding a return r̂.

1. (subsistence): Not working but investing wealth w on the safe asset.

2. (working labour): working at a wage rate, say v. It is easy to see that

v >1

δ= v

in order to induce choice of working.

Entrepreneurial projects are risky. It needs I amount of capital and oneunit of labour and yields return

r =

{r0r1

with probability qwith probability 1− q expected value r.

3. (Self-employment): Taking up an entrepreneurial project and use ownlabour in order to make it a success. When would that be feasible?

Ir ≥ 1δ+ Ir̂ and Ir ≥ 1

δ+ Ir0

Rearranging terms, we get the ’net effective return from investing effort inself-employment’must satisfy the following condition:

I (r − r̂)− 1δ≥ max {0, I (r0 − r̂)}

Finally,

4. (Entrepreneurship): Employ µ individuals, use their labour to take up µprojects, pay them a salary v, and use your own labour to monitor them.We assume risky returns

r =

{r′0r′1

with probability qwith probability 1− q

but with the same expected value r.

In order to have it sustainable, we need the following:

µ

[I (r − r̂)− 1

δ

]− 1δ≥ max

{I (r − r̂)− 1

δ, µ

[I(r′0 − r̂

)− 1δ

]}

Markets

Labour market through wage contract

Capital market (assumed to be imperfect)

Suppose w amount of collateral is needed to borrow L. What should be theminimum value of w needed to borrow L?

By repaying one gets,

V (L)− Lr̂ + (w − w) = V (L)− Lr̂

By defaulting one gets

V (L)− πF − wr̂

Comparing, we see that

L ≤ w +(πF

r̂

)

Define:

w∗ = I −(πF

r̂

)w∗∗ = µI −

(πF

r̂

)

Demand for labour

returns from different occupation with an initial wealth w

1. Subsistence

δwr̂

2. Wage labours

δ (wr̂ + v)− 1

3. Self-employment

δ (wr̂ + I (r − r̂))− 1

4. Entrepreneurship

δ (wr̂ + µI (r − r̂)− µv)− 1

Compare return from Entrepreneurship and Self employment to see that labourdemand is given by

Supply of labour

Compare returns from subsistence and wage labours

The equilibrium is at the intersection of the demand and supply curves.

Define pL = Gt (w∗), and pU = 1−Gt (w∗∗)

Two types of equilibrium.

If λpL > µλpU , then low wage equilibrium v = v.

Characteristics: Everyone below w∗ wants to work as wage labor, everyoneabove either self-employed or entrepreneur, depending on initial wealth. Onlya fraction of low-wealth individual absorbed in the wage market.

If λpL < µλpU , then high wage equilibrium v = v.

Characteristics: Everyone abovew∗ are indifferent from being self-employed andbeing entrepreneur. A fraction of population above w∗∗ remains self-employed.

Also note that if pL = 0 or pU = 0, then no one works as wage labour.

Second stage: from occupational choice to next period wealth.

Bequest:

1. Subsistence

(1− γ)wr̂

2. Wage labours

(1− γ) (wr̂ + v)

3. Self-employment

(1− γ) (wr̂ + I (r − r̂))

4. Entrepreneurship

(1− γ) (wr̂ + µI (r − r̂)− µv)

recursion diagram with v = v.

recursion diagram with v = v.

Dynamics of how two different equilibria may emerge (everyone self-employed,or entrepreneurial production)